An uptick in art rental appraisal requests

Article 01 June 2021 Experience: Art

This article was originally published in Trust & Estates, April 2021 Art, Auction & Antique Special Report.

The final months of 2020 saw a significant uptick in art rental appraisals. While perhaps an unusual trend in the art market, this uptick didn’t much surprise estate planners. As Joe Bidenemerged as the front-running presidential candidateby late summer, his proposals for tax reform elicited an increasing number of questions from high-networth individuals, including those with significant art collections, regarding the implications for their tax planning.

In 2020, estate and gift taxes applied at a rate of 40% to the extent that the total value of a taxpayer’s gratuitous transfers (accumulated during life and at death) exceeded $11.58 million, or $23.16 million for married couples.1 This threshold number (called the “unified credit”) is currently at a historic high.

In his presidential campaign, Joe Biden proposed lowering the unified credit to $3.5 million and increasing the estate tax rate to 45%. Naturally, this garnered the keen attention of affected taxpayers.2 If Biden were to be elected and tax reform passed at any point in 2021, tax advisors warned that existing case law supported the legality of imposing tax reform retroactive to Jan. 1, 2021.3 To proactively plan for this possibility, many tax advisors therefore suggested that their clients use any amount of unified credit they hadn’t already used up before 2020 year’s end to lock in the benefit of tax-free transfers up to the unusually high current unified credit amount: the “use it or lose it” approach.

To complete such planning within the final few months of 2020 required an asset readily available to gift. Art’s advantage is that it’s often a very high value asset that may be readily and privately gifted without involving a financial institution or public filings. Art may be gifted in a number of structures: to one donee or to multiple donees, either outright or via more complex family limited partnership planning.4 Significantly, the central value of art for many collectors lies in the enjoyment of seeing it displayed.

If it were possible for a collector to feel secure in accomplishing tax planning goals quickly and privately by making gifts of art before the end of 2020 and to continue seeing the art displayed in their home, would they be willing to pay a fee for that privilege? In 2020, the resounding answer was “yes” collectors were willing to pay such a fee. The art rental appraisal was the tool for setting that fee.

Implications of the Transaction

The situation in 2020 echoed the historic taxpayer preference for treatment under the gift tax rules over treatment under the estate tax rules. This was the case, not because of a coexisting inequality in treatment under the estate and gift tax rules, as was historically true, but rather due to a calculation that the gift tax rules in effect in 2020 were likely to be more advantageous than the estate tax rules in effect in future years under a Biden presidency.5 Therefore, taxpayers aimed to make a gift that would qualify as a complete transfer for estate and gift tax purposes in 2020, ensuring that their assets would be treated under the gift tax rules in effect in 2020 with finality and certainty.

One of the ways that the Internal Revenue Code guards against taxpayers characterizing lifetime transfers as gifts when they’re truly testamentary in nature is by pulling any asset transferred during a decedent’s lifetime back into the decedent’s estate if the decedent retained a significant “string” to the transferred asset. One such “string” is the retained beneficial enjoyment of the asset and appears in IRC Section 2036(a)(1). Section 2036(a) states that the value of a decedent’s gross estate for purposes of calculating estate tax shall include:

  • The value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death—(1) the possession or enjoyment of, or the right to the income from, the property…. [emphasis added]

The case law establishes that “enjoyment” is generally understood to mean substantial present economic benefit.6 For this reason, the phrase “possession or enjoyment” generally applies to transferred property interests that don’t yield income streams in a conventional sense, whereas the phrase “right to income” typically refers to income-producing property interests. To establish that Section 2036(a)(1) doesn’t apply, it’s therefore crucial to demonstrate that the substantial economic benefit has transferred from the donor to the donee along with title to the transferred property.

The potential frailty of a gift and lease-back is illustrated in a line of cases reviewing transfers of real property from parents to children when the parents then continue to reside in and beneficially enjoy such property.7 In this context, tax courts have established the basic principle that “we look to substance, not to form.”8 The cases demonstrate that the analysis can be very fact-specific, but that generally Section 2036(a)(1) doesn’t apply to a gifted asset that the donee leases back to the donor if: (1) fair, customary rental value is paid; (2) there was no agreement, express or implied, at the time of the gift that the property would be leased back to the donor; and (3) a clear borrower/lender relationship is demonstrated in the behavior of the donor and donee, including adherence to the terms of the governing instrument and reliance on professional tax advisors.9

Despite the numerous cases construing this provision, the gift and lease-back transaction remains largely untested in the art context. However, acknowledgment of Section 2036(a)(1) and its surrounding case law elicited the crucial planning strategy for those making transfers of art (but not transferring physical possession) during the final months of 2020: the art rental agreement.

Rental Agreement

A rental agreement in a gift and lease-back transaction should reflect standard market terms and conditions and should, at a minimum, address:

  • Lease period: Specify the period during which the lender has agreed to loan the art to the borrower.
  • Rental fee: Specify the rental fee and at what periodic intervals the fee must be paid. A procedure for updating the rental fee amount from time to time should be included.
  • Location and standard of care: State where the art will be located during the lease period and how the art will be maintained, and address authorization for reframing, restoration or conservation of the art.
  • Insurance: State the party insuring the art and the insured value.
  • Ownership: Re-state that the borrower doesn’t have any ownership rights to the art and isn’t authorized to encumber or sell the art.
  • Transportation logistics: On the expiration of the lease period and if the art must be relocated during the lease period, specify which party will arrange and pay for such arrangements.
  • Lender’s right of access: Provide the lender the right to access the art on notice to the borrower.
  • Termination rights: If the borrower fails to comply with the terms of the agreement, provide a mechanism by which the lender can terminate the loan period and recover the art.
  • Taxes: Include how the various taxes (sales taxes, use taxes, VAT and/or property taxes) will be paid.

Art Rental Appraisal

Aside from the loan agreement, the key element to a successful lease-back transaction is fair market value (FMV) rent. Of course, art is a notoriously difficult-to-value asset. Rental values for art maybe even more difficult to ascertain, as there’s no publicly accessible market (as compared with the auction market for art sales). Therefore, there’s an inherent risk that the IRS might challenge the FMV rent that the donor pays to the donee under the terms of a lease agreement. What can be done to mitigate this risk?

Use a reputable appraiser with appropriate expertise. Recognizing that there are no licensing or certification requirements to become an appraiser of personal property, even at the highest levels, and that the IRS hasn’t officially opined on FMV rental valuation, taxpayers are advised to take an above industry standard approach to selecting an appraiser. At present, the most rigorous standards required by the IRS when it comes to qualified appraisals and qualified appraisers are those applied to tax returns claiming charitable contribution deductions,10 and it’s recommended the FMV rental appraisals conform closely to these requirements (excluding those requirements that apply exclusively to charitable contributions). In short, the IRS defines a “qualified appraisal” as an appraisal document prepared by a qualified appraiser in accordance with generally accepted standards, such as the substance and principles of the Uniform Standards of Professional Appraisal Practice (USPAP). The appraisal document should include information regarding the art (or cataloging), its condition, the method of valuation, the specific basis for the valuation (such as comparables), FMV, etc., and the appraiser should meet certain educational, experience and/or professional affiliation requirements, as well as regularly prepare appraisals for which they’re paid, and they shouldn’t be deemed excluded individuals.11

Given the above requirements, the selected appraiser must have in-depth expertise in a specific area of art appraisal, such as Contemporary Art, Old Master Paintings and Impressionist & Modern Art, backed by an established track record of valuing that specific type of art under several market conditions, including the most recent. The appraiser selected should be affiliated with a reputable appraisal organization, such as the Appraisers Association of America, American Society of Appraisers or the International Society of Appraisers or meet the qualified appraiser education or experience requirements. Confirm that the appraiser has never been disqualified by the IRS in the past, and it’s also helpful to know if the appraiser has a strong reputation as an expert witness in litigated matters involving art valuation and how frequently their appraisals come under IRS review. To find an appraiser who meets these qualifications, in addition to the professional organizations mentioned above, consider speaking with advisors who regularly engage valuation experts on behalf of their clients, such as lawyers (Art Law, Trusts & Estates, Private Wealth, Marital Law), financial advisors (private wealth managers, trust officers and estate settlement teams), accountants and family office experts.

Use an appraiser with insight on current techniques and trends used to arrive at FMV rent. While specific methodology for determining a rental valuation is proprietary to the appraiser or appraisal firm, here’s the general approach: First, the appraiser must determine the FMV of the art as of a date around the start of the lease agreement by examining and analyzing works of like-kind and quality that have transacted in the most appropriate market. This will often primarily involve auction transactions, but frequently the private sale market must be considered as well. The appraiser will then determine an annual rental fee by objectively analyzing the market and determining the relative importance of the particular work of art within that artist’s oeuvre, while also considering factors such as condition, rarity, current market trends for the artist, the likely buyer base for the art and its overall liquidity. The annual rental fee is a percentage applied per annum on the FMV and is generally accepted to be within the range of 1% to 5%. Given that the basis of art rental valuation is a determination of a work’s desirability in the market, a defensible rental valuation is best suited for valuable works traded at the highest levels of the market.

Review the appraisal with a tax advisor with expertise in the art market. Consult with a tax advisor to review the appraisal and the loan agreement and to ensure that they each conform to current IRS standards and the art market standard for this type of appraisal.

Update appraisals regularly. An FMV appraisal must correspond to the current market conditions. Therefore, appraisals should be updated regularly.

Avoid appraisers who may have conflicts of interest. Avoid conflicts of interest at all costs, and make sure the appraiser isn’t associated with a prior transaction of the art being appraised. Consider Estate of Eva Franzen Kollsman v. Commissioner,12 in which the estate tax valuation of two 17th-century Old Master paintings was called into question. Following the decedent’s death, the estate’s expert, who was a vice president at Sotheby’s, valued the paintings. The Tax Court objected to and criticized the expert’s valuations for several reasons, including that the expert had a significant conflict of interest “that could cause a reasonable person to question his objectivity,” due to his solicitation for the right to sell the paintings at the same time that he provided the appraisal.

Observe Formalities

The careful observance of the formalities by the parties, a market-standard loan agreement and a solid rental value appraisal are crucial for gift and lease-back transactions, because, although there’s a long line of cases in the real estate context, the transaction is relatively untested with art. It therefore remains to be seen whether the IRS will challenge any of the transactions causing the 2020 uptick. Further, in the real estate context, this type of transaction has generally been disfavored by the IRS when the formalities aren’t diligently observed.

—The authors would like to acknowledge the assistance of Patrick Lin, Columbia Law School LLM Graduate.

[1] Certain transfers may be excluded from this calculation, such as the annual exclusion amount, currently $15,000 per donee. As a technical matter, we note that the estate and gift taxes are imposed at marginal rates, rising to a marginal tax rate of 40% at $1 million in transfers, but in light of the application of the unified credit, the estate and gift tax is effectively applied at a rate of 40%. Revenue Procedure 2019-44 provides the exemption amounts.
[2] See, e.g., Edward J. McCaffrey and Linda R. Cohen, “Shakedown at Gucci Gulch: The New Logic of Collective Action,” 84 N.C.L. Rev. 1159, 1164 (2006).
[3] See, e.g., Quarty v. United States, 170 F.3d 961, 965 (9th Cir. 1999). The court held that the increase in the unified estate and gift tax rate doesn’t violate the U.S. Constitution as a wholly new tax, but rather was merely an increase in an existing tax.
[4] The value of art is readily divisible among recipients and is subject to poten¬tial valuation discounts depending on how it’s transferred; for instance, if an art owner first transfers art into a limited liability company (LLC) that has an operating agreement stating that art can only be sold with the consent of all the LLC members, and then conveys membership interests in that LLC to her three children, each child could receive an equal membership interest, and those membership interests would, combined, be less than 100% of the value of the art contributed.
[5] In addition to locking in the gift tax rules that are in effect at the time the gift is made, another advantage to making a gift sooner than later is to “freeze” the value of the art, transferring it out of one’s estate based on its then-fair market value for gift tax purposes.
[6] United States v. Byrum, 408 U.S. 125, 145 (1972) (it’s well settled that the terms “enjoy’”and “enjoyment,” as used in various estate tax statutes, aren’t terms of art but connote substantial present economic benefit rather than technical vesting of title or estates); Treasury Regulations Section 20.2036-1(b)(2) (The “use, possession, right to the income, or other enjoyment of the transferred property” is considered as having been retained by or reserved to the decedent to the extent that the use, possession, right to the income, or other enjoyment is to be applied toward the dis¬charge of a legal obligation of the decedent, or otherwise for his pecuniary benefit); Badgley v. U.S., 957 F.3d 969, 977 (9th Cir. 2020); Estate of Gilman v. Commissioner, 65 T.C. 296 (1975), aff’d, 547 F.2d 32 (2d Cir. 1976); Revenue Ruling 75-259; Estate of Moore v. Comm’r, T.C. Memo. 2020-40.
[7] See, e.g., Estate of Stewart v. Comm’r, 617 F.3d 148 (2d Cir. 2010); Estate of Maxwell v. Comm’r, 3 F.3d 591 (2d Cir. 1993), aff’g 98 T.C. 594 (1992); Roemer v. Comm’r, 46 T.C.M. (CCH) 1176 (1983). See also Rev. Rul. 70-155.
[8] Estate of Church, 335 U.S. 632, 644 (quoting Helvering v. Hallock, 309 U.S. 106, 114 (1940)).
[9] Estate of Barlow, 55 T.C. 666 (1971), acq. 1972-2 CB 1, 3; Estate of Giselman, 55 T.C.M. 1654 (1988); and Private Letter Rulings 200825004 (March 6, 2008) and 200822011 (Feb. 9, 2008).
[10] See Internal Revenue Service Pub. 561 (Feb. 2020), www.irs.gov/publications/p561.
[11] Ibid.
[12] Estate of Eva Franzen Kollsman v. Comm’r, 113 T.C.M. (CCH) 1172 (T.C. 2017), aff’d, 777 F. App’x 870 (9th Cir. 2019).